Deciding how to split retirement savings during a divorce is no easy task, especially when spouses factor in potential tax implications or penalties that may be assessed on non-retirement withdrawals from 401K accounts.
Some early withdrawal penalties may be avoided by the use of a qualified domestic relations order, allowing spouses to retain more of their hard-earned savings.
Early withdrawal fees and authorized payees
According to the United States Department of Labor, distributions from an employer-sponsored retirement account like a 401K must generally be paid directly to the account owner. In the event that an account owner gets divorced and withdraws money from a 401K to pay a former spouse, early withdrawal fees will be assessed on the amount taken out. The account owner therefore must withdraw enough to pay the former spouse as well as the fees. Even when a couple’s divorce decree outlines the sharing of 401K funds, this may occur.
A qualified domestic relations order establishes the spouse of the account owner as an authorized payee. Once approved by the plan administrator, the authorized payee may receive funds directly from the account, bypassing the account owner altogether. No early withdrawal fees are assessed on these distributions.
Income taxes and authorized payees
Without a QDRO in place, distributions received by the account owner would require that person to claim the money as income and pay income taxes on it. The Internal Revenue Service explains that with the QDRO in effect, the authorized payee assumes liability for income taxes on any 401K funds received pursuant to the order. Reinvesting the funds into another retirement account eliminates the need to pay taxes at the time of receipt from the spouse’s account.